b.This is an expansionary fiscal policy because it is an
increase in government transfers that will increase dis-
posable income.
c.This is a contractionary fiscal policy because it is an
increase in taxes, which will reduce disposable income.
- Federal disaster relief that is quickly disbursed is more
effective at stabilizing the economy than legislated aid
because there is very little time lag between the time of
the disaster and the time when relief is received by vic-
tims. In contrast, the process of creating new legislation is
relatively slow, so legislated aid is likely to entail a time lag
in its disbursement, potentially destabilizing the economy. - a.An economy is overstimulated when an inflationary gap is
present. This will arise if an expansionary monetary or fis-
cal policy is implemented when the economy is currently
in long - run macroeconomic equilibrium. This shifts the
aggregate demand curve to the right, in the short run rais-
ing the aggregate price level and aggregate output and cre-
ating an inflationary gap. Eventually, nominal wages will
rise and shift the short - run aggregate supply curve to the
left, and aggregate output will fall back to potential out-
put. This is the scenario envisaged by the speaker.
b.No, this is not a valid argument. When the economy is not
currently in long - run macroeconomic equilibrium, an
expansionary monetary or fiscal policy does not lead to the
outcome described above. Suppose a negative demand
shock has shifted the aggregate demand curve to the left,
resulting in a recessionary gap. An expansionary monetary
or fiscal policy can shift the aggregate demand curve back
to its original position in long -run macroeconomic equilib-
rium. In this way, the short- run fall in aggregate output
and deflation caused by the original negative demand
shock can be avoided. So, if used in response to demand
shocks, fiscal or monetary policy is an effective policy tool.
Tackle the Test:
Multiple-Choice Questions
- e
- e
- b
- b
- a
Tackle the Test:
Free-Response Questions
- a.
b.Expansionary
Real GDP
Aggregate
price
level
YE YP
LRAS SRAS
AD
E
PE
shock, the aggregate price level rises and aggregate
output falls.
b.Increased investment spending shifts the aggregate
demand curve to the right. As a result of this positive
demand shock, both the aggregate price level and aggre-
gate output rise.
c.An increase in taxes and a reduction in government
spending both result in negative demand shocks, shifting
the aggregate demand curve to the left. As a result, both
the aggregate price level and aggregate output fall.
d.This is a negative supply shock, shifting the short - run
aggregate supply curve to the left. As a result, the aggre-
gate price level rises and aggregate output falls.
- As long - run growth increases potential output, the long -
run aggregate supply curve shifts to the right. If, in the
short run, there is now a recessionary gap (aggregate out-
put is less than potential output), nominal wages will
fall, shifting the short - run aggregate supply curve to the
right. This results in a fall in the aggregate price level and
a rise in aggregate output. As prices fall, we move along
the aggregate demand curve due to the wealth and inter-
est rate effects of a change in the aggregate price level.
Eventually, as long - run macroeconomic equilibrium is
reestablished, aggregate output will rise to be equal to
potential output, and the aggregate price level will fall to
the level that equates the quantity of aggregate output
demanded with potential output.
Tackle the Test:
Multiple-Choice Questions
- c
- a
- d
- b
- b
Tackle the Test:
Free-Response Question
Module 20
Check Your Understanding
- a.This is a contractionary fiscal policy because it is a reduc-
tion in government purchases of goods and services.
Long-run
macroeconomic
equilibrium
Potential
output
ELR
YP
LRAS
SRAS
AD
Real GDP
Aggregate
price
level
PE
S-12 SOLUTIONS TO AP REVIEW QUESTIONS